Chapter 5 - Pricing Flashcards
The optimum price of a product
- P = a + bQ
Where a is the intercept, b is the gradient. - MR = a - 2bQ
- Establish the MC. This will be the variable cost per unit.
- To maximise profit, MC = MR and solve to find Q.
- Substitute Q into the P = a - bQ to find the optimum price.
- May be necessary to calculate the maximum profit.
The price elasticity of demand
Measures the change in demand as a result of a change in its price.
Price elasticity of demand = Change in quantity demanded, as a % of demand/ Change in price as a % of the price
Interpretation of PED
Elastic demand.
If % change in demand > % change in price then price elasticity > 1.
Demand is elastic (very responsive to changes in price).
- Total revenue increase when price is reduced.
- Total revenue decreases when price is increased.
Price increases are not recommended but price cuts are recommended.
Inelastic demand.
If % change in demand < % change in price then price elasticity < 1.
Demand is inelastic (not very responsive to changes in price).
- Total revenue decreases when price is reduced.
- Total revenue increases when price is increased.
Price increases are recommended but price cuts are not recommended.
Equation for the total cost function.
y = a + bx
a is the Fixed cost (intercept).
b is the Variable cost per unit (gradient).
X is the activity level (independent variable).
Total cost = Fixed cost + Variable cost (dependent variable).
Profit mark up and profit margin
Profit mark up: The profit is quoted as a percentage of the cost.
e.g. A 25% mark up of $540 would be $540 x 1.25 = $675
Profit margin: The profit is quoted as a percentage of the selling price.
e.g. A 25% profit margin of $540 would be $540 x 100/75 = $720
Market skimming pricing strategy
- Involves charging high prices when a product is first launched in order to maximise short-term profitability.
- Initially high prices charged to take advantage of the new product when demand is initially inelastic.
Conditions suitable:-
- Where the product is new and different.
- Where products have a short life cycle and there is a need to recover costs quickly to make a profit.
- Where the strength of demand and the sensitivity of demand to price are unknown. Start high then lower price if needed.
- A firm with liquidity problems may use market skimming in order to generate high cash flows early on.
Penetration pricing strategy
- Involves charging low prices when a new product is initially launched in order to gain rapid acceptance of the product.
- Once market share is achieved, prices are increased.
Conditions suitable:-
- If the firm wishes to increase market share.
- A firm wants to discourage new entrants to enter the market.
- If there are significant economies of scale to be achieved from high volume output and so a quick penetration into the market is desirable.
- If demand is highly elastic and so would respond well to low prices.
Complementary product pricing
A product which is normally used with another product.
e.g. Razors and razor blades, games consoles and games, printers and printer cartridges.
- The major product is priced low to lock the consumer into subsequent purchases of high price consumables.
- The major product is priced high to create a barrier to entry and exit and the consumer is locked into subsequent purchases of low price facilities.
Product line pricing strategy
A range of products that are related to one another. All products are related but many vary in terms of style, colour, quality, price etc.
Product line pricing works by:-
- Capitalising on consumer interest in a number of products within a range.
- Making the price entry point for the basic product cheap.
- Pricing other items in the range more highly.
Volume-discounting pricing strategy
Offering customers a lower price per unit if they purchase a particular quantity of a product.
The main forms are:
- Quantity discounts - customers that order large quantities.
- Cumulative quantity discounts - the discount increases as the cumulative total ordered increases.
Benefits:
- Increase customer loyalty.
- Attracting new customers.
- Lower sales processing costs.
- Lower purchasing costs.
- Discounts help to sell items that are bought primarily on price.
- Clearance of surplus stock or unpopular items through discounts.
- Discounts can be geared to particular off-peak periods.
Price-discrimination pricing strategy
Where a company sells the same product at different prices in different markets.
Conditions required:
- Seller must have some monopoly power or the price will be driven down.
- Customers can be segregated into different markets.
- Customers cannot buy at lower price in one market and sell at higher price in the other market.
- There must be different price elasticities of demand in each market so that prices can be raised in one and lowered in the other to increase revenue.
Dangers:
- A black market may develop where those in a lower priced segment resell to those in a higher priced segment.
- Competitors join the market and undercut the firms prices.
- Customers in the high bracket look for alternatives and demand becomes more elastic over time.
